Financing a Business

  Dr. Clive Vlieland-Boddy
      Core areas of the module
•   Financial management function
•   Financial management environment
•   Working capital management
•   Investment appraisal
•   Business finance
•   Cost of capital
•   Business valuations
•   Risk management
The Financial Management
   The Financial Management
• Raising finance
• Investing funds raised – this includes
     • allocating funds and
     • controlling investments
• Dividend policy – returning gains to
Corporate Strategy & Objectives
Corporate Stakeholders
            Agency Theory
• Agency relationships occur when one
  party, the principal, employs another
  party, the agent, to perform a task on their
• Objectives of principals and agents may
  not coincide
• Problem of goal congruence
• The balance sheet
  – Summaries Assets & Liabilities.
  – Current assets are financed with current obligations
  – Long-term debt and equity finances long-term assets

• You should not finance long
  term assets with short term
• Debt and Equity Capital: Two Basic
  Sources of Funds
        Sources of Funds
• Debt capital—funds obtained through
• Equity capital—funds provided by the
  firm’s owners when they reinvest earnings,
  make additional contributions, or issue
  stock to investors.
       Financial Management
     -Internal Sources of Funds
Profit   The after-tax profit earned and
          retained by a business which is an
          important and inexpensive source
          of finance.
         These are the Retained Earnings
          of the business.
         A large part of finance of most
          businesses is funded from profits
          left in the business.
Comparison of Debt and Equity Capital
          Type of Funding
Short Term
• This should only be used for short term
  needs. This means that financing Non
  Currents Assets should NOT be funded
  with short term money.
Long Term
• This means that it borrowed for more than
  one year.
         Short Term Money
• Bank overdraft
• Here the company arranges a facility with
  its bankers to allow funding to cover short
  term cash flow issues.
• Accounts Payable can enable working
  capital to be funds short term problems.
• Inventory management or Credit control
  can also help.
   Long Term Money - Equity
• Retaining Earnings and not paying
• Issuing more new shares.
• M&M’s view of this!
       Long Term Money - Debt
• Debt by way of a loan for 1-20 years. These
  will be advanced against the 3 key
  – Security
  – Serviceability
  – Commitment
• Remember debts interest and repayments
  have to be made on due dates.
• Tends to be less expensive than equity due
  to risk and tax shield.
              Capital Structure
              Debt and Equity
• The basic feature of a debt is that it is a promise
  to repay a fixed dollar amount of by a certain date.
• The shareholder’s claim on firm value is the
  residual amount that remains after the debt
  holders are paid.
• If the value of the firm is less than the amount
  promised to the debt holders, the shareholders
  get nothing.
            Debt Vs Equity
• Interest and Capital repayments have to
  be made in accordance with the loan
• Dividends are only paid to shareholders if
  there is money available.
             Debt & Interest
• These always have to be paid. If not the
  company is insolvent and likely to go bankrupt.
• Interest is based on what the lender requires. It
  is usually a market rate. Currently say 5%.
• Interest is tax deductable.
• This means the net cost of borrowing by way of
  debt is reduced even further.
• Say 5% interest less tax at 30% means net cost
  is only 3.5%.
• This tax benefit is called the Tax Shield.
         Equity & Dividends
• Whilst nice, dividends don’t have to be
• Dividends are not tax deductable.
• Equity investors are usually greedy
  demanding substantial returns usually in
  excess of 20%.
• Why if Debt is only 3.5% net and Equity is
  over 20% net, aren’t all companies 100%
  debt financed?
• The issue is that there is a commitment to
  pay the interest and repayments of the
  debt. In good times this is not a problem
  but when things start to go wrong then
  they are.
Financial leverage concepts
  – The traditional view is that an optimal mix of
    debt and equity exists
  – Research demonstrated that the mix of debt
    and equity is irrelevant, if taxes are ignored
  – The tax deductibility of interest expense
    creates an advantage for incurring debt
• The advantage of debt only exists up to a
  – Low cost debt increases ROE relative to ROA
  – Debt can become so costly that it reduces
    ROE below ROA
• Leverage is the technique of increasing the rate
  of return on an investment by financing it with
  borrowed funds.
• The key to managing leverage is ensuring that
  the company’s earnings remain larger than its
  interest payments.
• This increases the leverage on the rate of
  return on shareholders’ investment .
• Many say that all companies should be 100%
  debt finance but that ignores the risk of
  bankruptcy factor.

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